Comments on Christensen

The other day I praised Lars Christensen’s survey of the new Market Monetarism School. Apparently, Lars was a bit overwhelmed by my comparison of his survey to Friedman’s 1956 restatement of the quantity theory and the 1976 paper by Johnson and Frenkel on the monetary approach to the balance of payments. In fact, Lars, in some respects at any rate, outdid both Friedman and Johnson and Frenkel. After all, he avoided making any remark even remotely comparable to Friedman’s infamous reference to a non-existent Chicago oral tradition or even the gross error made by Johnson and Frenkel of citing David Hume as a forerunner of the monetary approach based on his exposition of the price-specie-flow mechanism when the monetary approach implies that the price-specie-flow mechanism is not how the gold standard operated (as demonstrated by McCloskey and Zecher in their paper in the volume edited by Johnson and Frenkel in which their paper was the opening chapter). But the point of my comparison was more contextual than a comparison of the papers as such. The common characteristic of the three papers is how they provide a clear summary of and introduction to the key issues raised by a new literature along with an account of the historical origins of the new theory. Such a survey paper serves a really important rhetorical (to use McCloskey’s idea) role in propagating new set of ideas and making them accessible and attractive to a broader group of readers than those actively involved in developing those ideas. Well done, Lars.

But despite my genuine admiration for Lars’s accomplishment, I did not agree with everything he wrote, so in this post, and perhaps some future posts as well, I will explain why I look at things a bit differently from how Lars does, though it is not clear whether what Lars writes always reflects his own views or actually reflects those of some or all of the Market Monetarists whose views he is surveying.

So I shall begin my commentary with the first substantive section of Lars’s paper under the heading “Recessions are always and everywhere a monetary phenomenon.” The discussion in this section concerns the idea that an aggregate excess supply of goods (which is how economists often characterize an economy in recession) must be matched by an excess demand for money. Now that way of thinking about recessions is well-established and not really very controversial, but I have serious reservations about it. First, it treats all money as if it just came into existence out of thin air and not as the result of a voluntary economic transaction with a supplier and a demander. In other words, most money has come into existence as the result of a banking transaction in which a deposit (the bank’s liability) was created in exchange for an individual’s liability, the liability of the bank, unlike that of an individual, being generally acceptable in exchange.

Lars (pp. 3-4) then quotes Nick Rowe as follows:

In a monetary exchange economy, with n goods including money, there are n-1 markets. In each of those markets, there are two goods traded. Money is traded against one of the non-money goods.

Nick is here giving formal expression to the old idea of money as a hot potato, once created it is there and can only be passed from one pair of hands to another; it can’t be gotten rid of. Following Jim Tobin’s classic paper (“Commercial Banks as Creators of Money”) I reject that view of bank money. Bank money is created by banks in the course of economic transactions designed to satisfy a demand, and can be extinguished by a corresponding transaction in the opposite direction. So I don’t accept the proposition that an excess demand for (supply of) bank money necessarily corresponds to an excess supply of (demand for) real goods. There is a market for money backing services in which an excess demand for (supply of) money finds its counterpart in an excess supply of (demand for) money backing. The price that is determined in this market for bank money is the interest paid on deposits, which adjusts as needed to equilibrate the supply of deposits with the demand to hold deposits.

That’s why I believe, unlike traditional (and Market) Monetarists, that the price level and associated macroeconomic variables like employment and output should be viewed as being determined strictly in terms of government currency, with any disequilibrium between the supply of and demand for bank money being viewed (at least as a first approximation) as triggering an adjustment in the interest paid on deposits rather than on the excess demand for real goods. (Bill Woolsey and I had an exchange on this point a few weeks ago in the comments to my post “Are Recessions Efficient?”). I have the impression (perhaps mistaken) that Scott Sumner actually may be closer to my position than to Nick Rowe’s and Bill Woolsey’s on this point, but Scott can weigh in for himself on this.

The policy significance of this disagreement may actually not be that great, because an equilibrium view of money creation by banks does not imply that monetary policy is ineffective as Tobin mistakenly concluded, inviting the everlasting (and in my view completely misguided) hostility of Monetarists to his understanding of money creation by banks. At any rate, in my view of the world, the price level is determined in a market for currency and (when it is not interest-bearing) bank reserves. There is a supply of and demand for bank money convertible into currency whose equilibrium determines the interest paid on bank deposits. And finally, the money multiplier is cast into the theoretical dustbin as a useless and hopelessly senseless confusion of supply and demand concepts.

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24 Responses to “Comments on Christensen”

“The discussion in this section concerns the idea that an aggregate excess supply of goods (which is how economists often characterize an economy in recession) must be matched by an excess supply of money.”

I believe you made a typo. An excess supply of goods (demand for goods < supply) must be matched by an excess demand for money.

You are both wrong on substance. What would happen if the Fed (and private banks) suspended currency payments today? What happens if the demand for currency falls to zero and all of it is withdrawn from circulation? The payment of interest on money has some effects, but nothing too fundamental.

I thought I had worked this post out until the end (I thought it was an old “narrow money or broad money/currency or deposits?” debate) but then the (correct) rejection of the Money Multiplier reminded me that you’re not a monetarist, including a narrow-money monetarist (what Tim Congdon calls “American Monetarism”).

So am I on the right track if I say that you believe that narrow money (and specifically M0 rather than M1, i.e. the wide monetary base rather than transaction money?) is what is important, though you reject the Money Multplier story? Obviously, I am going to read up on the various nuances here (I haven’t read James Tobin or Hawtrey yet, for instance) but I’d like to make sure I haven’t totally misunderstood you.

David: suppose the Bank offers to lend me $100, and I agree. So it credits $100 to my chequing account. But I didn’t borrow that $100 just to hold it in my chequing account (presumably). I borrowed it to spend it. There is now a $100 hot potato in circulation.

I’m channeling Yeager and Laidler here. James Tobin was wrong. A willingness to *accept* money in exchange for goods (or for a promise to pay that money back 10 years from today) does not imply a willingness to *hold* that money. It (nearly always) implies a plan to turn right around and spend that same money (or most of it), on some other goods.

The medium of exchange is not like other goods. If people don’t want to hold more stocks of furniture, it would be impossible for the suppliers of furniture to increase the stock in public hands. If people don’t want to hold more stocks of money, it is still perfectly possible for suppliers of money to increase the stock of money in public hands.

Assume, just for the sake of argument, that the demand for (the stock of) money were perfectly income inelastic and perfectly interest inelastic, and that all prices were fixed by law. And that the economy is in a recession, with an excess supply of all goods. If James Tobin were right, it would be impossible to increase the stock of money. He was wrong. The supplier of money simply buys something. That extra stock of money then just hot potatos forever.

Bill, Thanks for supporting my conjecture that Scott agrees with me. As for who is right on substance, we will have just have to let that one stand as an unresolved question for the time being. I am not sure what you mean by the Fed and private banks suspending currency payments. The Fed issues currency, so do you mean that currency disappears from the economy? Are you asking me about your proposal to have all hand to hand money issued by private banks with the Fed providing only reserves to the banking system? In principle, everything the Fed is now doing could be accomplished through its control over reserves. So I don’t see that change as changing the process of price level determination in a fundamental way. If money bears competitive interest then there is no reason for anyone with more money than he wants to spend it, he just lets it sit in his bank account and collects interest. Banks on the other hand, earn no profit at the margin from issuing another dollar, so the public is satiated with liquidity and no bank has an incentive to expand, so the banking system is in full equilibrium, the price level is determined by the supply of and demand for currency or base money, and all is well with the world.

W. Peden, I am not sure that I exactly follow what you are asking. I don’t pay any attention to MO, M1 or whatever other monetary aggregates people are keeping track of these days. As I said, I look at the money issued by the government (which includes the Fed) and is non-interest-bearing. In the US that is hand-to-hand currency. Even though we are really talking about the solution of a general equilibrium system, for expositonal purposes, you can think of the value of currency being determined in terms of the fixed stock of currency relative to the demand. Since bank money is convertible into currency, whatever value for currency is consistent with GE for the economy determines the value of the bank money convertible into currency. It’s just like a gold standard in which bank money is convertible into gold and the value of gold depends on the demand for gold (for monetary and non-monetary uses) relative to the fixed (in the short-run) stock of gold.

Nick, It is not a hot potato, because the bank knows that the marginal profit from issuing the dollar equals spread between the difference between the lending and deposit rates on the one hand and the intermediation cost on the other hand. In equilibrium those two have to be equal, so whenever there is excess money around banks will see that marginal cost exceeds marginal revenue and will take their hot potatoes off the market. John Fullarton figured this out in 1844 and called it the Law of Reflux. It took almost 120 years for Tobin to work out the argument fully, but it’s essentially all in Fullarton. Reading Perry Mehrling’s wonderful biography of Fischer Black, I learned to my astonishment that Fischer also figured this out in the late 1960s and early 1970s and then found that Fullarton had worked out in 1844. Mehrling doesn’t make any reference to Tobin in this context. Black had just arrived at Chicago and tried to explain all this to Milton Friedman, but all Friedman could do was tell Fischer that he was simply repeating the real-bills doctrine fallacy that Lloyd Mints had refuted (over and over and over again) in his book on the history of banking theory. As a result of Friedman’s bullying, Black left Chicago for MIT. I am happy to take Fischer Black’s side in this debate.

Sorry, Nick, but channeling Yeager does nothing for me, see his review of my book here. David Laidler is another story, since he is one of my favorite economists and people in the whole world, but you will have to convince me that he rejects Tobin’s analysis. I am not sure that I follow your example, but it seems to me that you are not properly distinguishing between the analysis of the fixed supply of interest-inelastic currency and the elastic supply of interest-bearing bank deposits. But you are in good company, that was the one part of the analysis that Tobin didn’t quite get. He thought that he was proving that money in general had no effect on prices when in fact he was proving that bank money has no effect on prices (except insofar as the supply of bank money affects the demand for currency).

Good that you agree that everything can be done with reserves balances just like currency.

If you imagine that there is one interest rate in the world and the Fed is paying that rate on reserve balances, then the situation is more than a bit peculiar. What happens is that the Fed must set that interest rate just right, which makes saving equal to investment and the quantity of money equal to the demand to hold money.

However, if the interest rate paid on reserves is less than the interest rates on other securities, things aren’t nearly so peculiar. And no currency is needed.

I agree that redeemability restrains individual private banks and the private banking system.

But paying interest rates on deposits really has nothing to do with it. If private banks only issued currency, or interest on deposits was banned, redeemability would still restrain the issue.

Outside of a Walrasian auctioneer, there is no way that the interest rate on deposits will adjust like an ordinary market price to keep the quantity of money demanded equal to the current quantity.

Excess supplies or demands for the monetary base, whether currency or not, result in changes in nominal expenditure by causing excess supplies or demands for deposits. (Almost entirely when base money is used as hand-to-hand currency.)

And excess supplies or demands for deposits are equilibrated by redeemability–that is, by causing excess demands or supplies of base money.

In equilibrium, competitive banking systems create deposits with yields that are lower than the return on earning assets by the cost of providing intermediation services. But there is no disequilibrium process where an excess supply of deposits is immediately cleared by a higher interest rate on deposits or an excess demand for money is immediately cleared by a lower interest rate on deposits.

Well, the above conversation is all fine, but I think we should print a lot more money. I would throw it out in the street in paper grocery bags if I could, preferably in lower-middle income neighborhoods where they would spend it.

You said: “Nick, It is not a hot potato, because the bank knows that the marginal profit from issuing the dollar equals spread between the difference between the lending and deposit rates on the one hand and the intermediation cost on the other hand.”

But when the bank extends a $100 loan, and $100 deposit, it knows that the loan will stay on its books for (say) 5 years, but the deposit will only stay on its books for (say) 5 days. The deposit will (almost certainly) be spent, and reappear on the books of a second bank. All the first bank is looking at is the interest on the $100 loan and the cost of funds to replace the reserves it will lose when the deposit switches to the second bank.

David: “because the bank knows that the marginal profit from issuing the dollar equals spread between the difference between the lending and deposit rates on the one hand and the intermediation cost on the other hand.”

No, Nick is right(er) here. Unless it’s an *extremely* large bank the marginal cost of funds is the interbank rate. They don’t keep the deposits they create.

” In equilibrium those two have to be equal, so whenever there is excess money around banks will see that marginal cost exceeds marginal revenue and will take their hot potatoes off the market”

If there’s excess money around banks are earning extra seignorage profits. It’s borrowers who see that their seignorage costs are too high and who therefore pay off their loans, thereby reducing the money supply. But you are right about the effect.
I agree with you that currency is roughly “non-interest bearing money”. (I think would should scale each dollar of currency by how much less it earns than the interbank rate – some money is hotter than others). The confusion seems to

David, I have had to read several times your post and the Nick Rowe´s one to understand the point. I´m not sure of having get it.
If I´ve understand something right, You say that the market of bank deposits is balanced by the interest rate, not by the price level. That demand and supply of deposit is not inelastic to interest rate.
That is different to money supply of central bank, that is the only money that does move the price level.
So, bank money is not determined by monetary base? never? bank money can counterbalance monetary base movement? In that case, the monetary policy is more dificult to achieve, I suppose.
I don´t understand well the Law of Reflux.

Bill, Banks have to make their deposits redeemable in terms of some outside asset otherwise there will be no demand for their deposits to be used as a medium of exchange. A new medium of exchange has to be compatible with an existing network, that is accomplished by one-to-one convertibility. Clearly once bank deposits are convertible into currency or base money, the value of deposits must equal the value of currency. But banks are inclined to increase the supply of deposits by lending out any excess reserves they have so the issuer of base money has to figure out some way to keep the banks from expanding (reserve requirements) otherwise you get inflation or a credit cycle driven by waves of bank expansion and then contraction when there is a shortage of reserves. I also can’t tell whether you disagree with me because my model doesn’t make sense or because you believe it doesn’t fit the facts. It would be helpful if we could keep those two discussions separate.

Ben, I can always count on you to keep the discussion from going off topic. You keep our eyes on the prize.

Nick, I don’t think it is useful to view banks as if they are lending out their reserves in the way the standard story encourages one to think about the creation of bank deposits. In order to lend, banks have to acquire capital, they can either get capital from investors, borrow long-term, borrow from the inter-bank loan market or they can obtain capital by creating deposits. The latter is the only way that they are affecting the money supply. Any loans that they are making in excess of the deposits created are financed by a transfer of capital to the bank by owners or lenders. So from the standpoint of a bank as a money supplier, its ability to lend is limited by its ability to create (and maintain) a deposit base on which to rely as a soruce of capital for lending. To maintain a deposit base, it must provide a variety of services to depositors and it must pay depositors a competitive interest rate. So if banks can’t sustain deposits they can’t continue to lend unless they can find another source of capital, and to that extent their lending is not associated with money creation.

K and Luis, I hope that the above response to Nick helps you understand how I think about deposit creation. I hope you will forgive me for shameless self promotion, but you could also consult the first chapter of my book.

David: David Laidler replies to me by email: “Yes, you are indeed echoing my view with perfect accuracy…”

While it is true of course that a bank does not literally lend its reserves, an individual bank that extends a loan by creating a deposit knows that it is very likely that that deposit will be spent, and redeposited in a second bank, and that the first bank will therefore lose reserves to the second bank.

I interpret the standard textbook story as an attempt to tell a hot potato story. Or rather, two hot potato stories at once. Starting in equilibrium, the central bank creates an excess supply of reserves. That excess supply of reserves hot potatos around the banks. But as banks pass on the hot potato of reserves, they extend loans by creating deposits. And those deposits hot potato around the public. And that second hot potato will be bigger than the first hot potato, under fractional reserve banking.

Individual banks will compete for deposits. That means they compete to get people to *hold* deposits. The larger the stock of deposits they can persuade people to hold with them, the larger the stock of loans they can hold on their book, ceteris paribus. It’s a competition between individual banks for market share. But the total size of that market changes as a result of the disequilibrium hot potato process the standard story attempts to describe.

What is missing from the standard story is any discussion of the public’s (stock) demand for money. And that, I think, may be at the root of what you don’t like about the standard story. And it is indeed absolutely weird that a model should talk about what determines the total stock of some asset by talking only about the supply side of the market with no mention of the demand for that asset. But, if my view is correct, that weirdness is exactly how it should be. The medium of exchange is not like other assets. The suppliers of money can increase the actual stock without having first to increase the quantity demanded.

edeast, I meant that in traditional expositions of the money multiplier process which works out the logic of the money is a hot potato story, reserve requirements are viewed as one of the ways to keep commercial bank s from blowing up the system by creating an infinite amount of deposits. But you’re right the Canadian system works fine without reserve requirements. I have no problem with that.

Nick, Thanks for forwarding David’s confirmation of your faithful representation of his views. I hope that my expression of doubt that you were accurately reflecting his views caused no offense, but in my occasional meetings and correspondence with David over the years in which we have talked about the notion of a competitive supply of (bank) money, I never got the impression that he thought that there was something fundamentally wrong with the way I conceived of the money supply process. Obviously, when I next see David, we will have a lot to talk about. At any rate, despite my disappointment at having to take issue not only with you but with David, I see no reason to change my views.

I agree with you (in opposition to Mike Sproul) that government currency is a hot potato and spending and prices have to adjust to accommodate that hot potato. What forces you to accept the second hot potato story that you admit is weird and ignores the demand to hold deposits (though smuggled in surreptitiously on the supply side through the currency deposit ration in the money multiplier!) even though you admit that each bank in order to engage in lending through the creation of deposits must take actions — competitive actions — aimed at increasing the amount of its deposits demanded by the public? At some level, our two views may be translatable into each other, but why, other than the force of a tradition going back to CA Phillips in the early 20th century, would anyone want to stick with the money multiplier paradigm in preference to a marginal revenue and marginal cost paradigm?

David: no offence taken at all. I don’t trust my own memory on this stuff either! (I now think I might have been wrong, for example, in attributing the refrigerator analogy to Milton Friedman!

Let me think some more about how best to reconcile your views with mine. It might be, for example, that you are describing the equilibrium and I am describing the disequilibrium process that gets us to that same equilibrium.

Out of competitive equilibrium Qd /= Qs. So what determines Q? The normal answer, for any other good, is that the short side of the market determines Q. Q=min{Qd,Qs}. But money is different. It does not have a market of its own. I have argued that, out of competitive equilibrium, M=Ms, rather than the short side rule.

I’m still having trouble finding the disagreement here. Here’s what I believe, FWIW:

The most logical way of thinking about the monetary transmission mechanism is via base money. Anything that creates an excess supply of base money at the current price level tends to force prices up. That seems to support David.

There are actions that banks might take to boost deposit money, which would have the side effect of creating an excess supply of base money at the current price level. A dollar of deposit money requires much less base money than a dollar of hand to hand currency (for which $1 of base money is obviously required.) That would seem to support Nick’s argument.

On the other hand those bank actions might also affect the equilibrium interest rate, in which case perhaps David’s “as a first approximation” still holds. I don’t know–that’s an empirical matter.

I’m not a fan of using logic to evaluate monetary economics claims. The “law of reflux” seems vague to me. What is “over-issue?” Is the debate about whether banks should be regulated to make the multiplier stable? I say no. Is the debate about whether technological innovations in banking or boom mentality might change the price level via larger M2? I say yes, it’s possible if the Fed was asleep. I’d add that, for a given monetary base, the legalization of drugs would sharply raise the price level. I don’t find that fact very interesting, and I also don’t find facts about the banking system to be very interesting. I’m interested in money, not banking. For me money is the base, although I can understand why some prefer different definitions. I’d rather debate any policy implications that arise from those different definitions. Otherwise I have trouble seeing what I’m debating.

Nick, I am afraid that there is still a disconnect between us, despite Scott’s attempt to smooth things over. You seem to want to treat all money as a single homogeneous entity whether it is issued by the government (central bank) or by commercial banks and therefore argue that there is no separate market for money. I on the other hand say that there is no separate market (in your sense) for money issued by the central bank, but there is a market for money created by commercial banks (which they make convertible into government money). There is a market for the money created by commercial banks because it bears a competitively determined interest rate. So that when the quantity of bank money demanded does not equal the quantity supplied, there is a market disequilibrium that works itself out to bring about an adjustment in the quantity of bank money or in the interest paid on deposits. The adjustments need not be instantaneous, but they can eliminate the excess demand or supply of bank money faster than changes in aggregate spending. On the other hand, a disequilibrium between the quantity of currency demanded and the amount supplied can only be eliminated by changes in aggregate spending, changes that also induce changes in the amount of bank money demanded and supplied, so what looks like a money multiplier effect is really just an induced change in the demand for bank money which induces an automatic response in the quantity supplied.

Scott, I agree that if banks become lower cost suppliers of money, so that they can for example increase the interest they pay on deposits, the public will choose to reduce the amount of currency that they hold creating an excess supply of currency thereby increasing spending and driving up prices. Adam Smith describes this process in the Wealth of Nations explaining how banks can cause inflation by reducing the monetary demand for gold. So it was perfectly well understood almost 150 years before the money multiplier was invented.

I assume that money, and the monetized economy, is transactional. Nick Rowe: I’m sure you don’t mean that the “hot potato” in the economy is simply excess supply. It results from market successes and failures. Bank credit needs a counterparty. If a bank “injects” money by buying something, it needs an asset seller. Counterparties repay loans, which may reduce money supply. But successful counterparties may continue to profit without loans, which motivates more loans to other counterparties. Then again, sometimes counterparties fail to repay loans, yet $ spent by the bankrupt may still circulate. Too many bankrupt counterparties leads to bank failure. There’s more here than simple equilibrium equations.

Credit may be extended as a discount on future income, but it often has a literal or tacit asset backing. Bank mortgages supply credit to a buyer, currency to a seller, and (often overlooked) lien on an asset. Ownership matters. In the housing bubble, banks “owned” an increasing share of houses. House values impact bank balance sheets. A drop in housing demand threatened bank values, even if people continued to pay their mortgages. To maintain housing prices, demand was propped up by subprime lending.

Bill Woolsey asks “What happens if the demand for currency falls to zero and all of it is withdrawn from circulation?” Questions matter as well as answers. This one is like asking what would happen if humans didn’t need oxygen. If demand falls to zero, it would require a radically new sociological underpinning, just as if humans didn’t need oxygen, life would require a radically different sort of evolution.

About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.